Buckle Your Seat Belts for October
By Paul Hoffmeister, Chief Economist
This month, there will be a lot going on macroeconomically that could move markets significantly. On October 10, US-China trade negotiations will be held in an attempt to break the deadlock both sides have reached in recent months; a European Union summit will take place on October 17, and Brexit will be the top issue; the FOMC will meet on October 29-30; and the current, official deadline for Brexit is October 31. All the while, political uncertainty is erupting as Congress undertakes an impeachment inquiry of President Trump.
As we see it, the world’s most important macro variables are “in play” during the next 30 days. In this client letter, we will answer some of the most popular questions related to these issues.
Is the US going into a recession? It’s getting too close for comfort.
Will the more than 3-year uncertainty over Brexit finally culminate with the UK’s exit from the EU by month-end? People might be sleeping on this scenario; it has a higher probability of happening than some might believe.
Will the US and China put an end to their trade dispute, which arguably sparked the big US equity selloffs in May and August? Prospects are good for a partial deal; not so good for a comprehensive settlement.
What’s the 2020 election outlook and policy implications? It appears that it’ll be Trump v. Warren, but don’t count out Hillary Clinton. Also pay attention to healthcare providers, which seem to be the most sensitive sector to election news.
Lastly, would a presidential impeachment be a serious market risk, and are Republicans in trouble in 2020? Yes, we believe it’s a serious market risk when considering how markets traded during the late summer of 1998 when the Clinton impeachment events began to heat up. As for Republican electoral prospects next year, they could be even stronger if the 1998 midterms are a clue. Furthermore, the Trump re-election campaign may be the most formidable in history in terms of money, and its voter targeting has so far been a competitive advantage versus Democrats.
Is the US economy going into a recession?
While I’ve been a critic of Fed policy in recent years, I believe there’s a good chance that the economy can still avoid recession.
To be clear, I’ve been critical of the Fed’s interest rate increases during the last 1-2 years because: 1) it was intentionally sought by many supporters as necessary to ensure that the economy didn’t overheat (I disagree with the notion that too many people working is a bad thing, and that low unemployment can spark an inflation spiral); and 2) rate increases were excessively flattening and inverting the yield curve (which is an ominous forward-looking indicator).
Arguably, the combination of higher interest rates and macro uncertainty that’s inhibiting risk-taking, such as trade frictions and Brexit, have been the primary factors behind the economic slowdown we see today. And the US economy is inching closer to recession.
According to the Institute for Supply Management, the ISM Manufacturing Index peaked in August 2018 at 60.8 and the Non-Manufacturing Index peaked a month later (September 2018) at 60.8 as well. As of September 2019, the indices respectively registered 47.8 and 56.4, indicating that the US manufacturing sector was contracting while the non-manufacturing sector was still growing albeit at a slower pace than a year ago.
Given this economic data and the fact that the 3-month/10-year Treasury spread is inverted by approximately 18 basis points today, according to the St. Louis Federal Reserve, it’s understandable that recession fears are mounting and growth is likely trending toward 1%. But the good news is, despite the economic damage of the last year, recession could be avoided.
First, interest rate futures at the Chicago Mercantile Exchange currently imply an 88.3% probability of another quarter-point rate cut by year-end, which could lift much of the yield curve out of inversion. Second, many Fed officials are no longer focused on the unemployment rate, but on external risks, such as the global slowdown and trade tensions. Third, the job market remains in decent shape. It’s not as strong as a year ago, but it’s not meaningfully deteriorating either. Fourth, some credit market spreads have narrowed this year, suggesting a healthier risk-taking environment today compared to late 2018, early 2019.
The confluence of these factors could keep the United States out of recession during the near-term.
Without question, though, we believe major negatives continue to weigh on the economy, such as the weak manufacturing sector and the uncertainty surrounding Brexit and US-China trade. Resolution and clarity in both could spark a resurgence in global growth. Contrarily, the more these uncertainties drag on, the greater the headwinds to growth.
Importantly, it has been hugely positive that the Fed has been more dovish this year and has undone two quarter point rate increases already. In our view, we need the Fed to remain dovish, and markets likely won’t be pleased if Fed policymakers question whether further rate reductions are necessary.
It’s worrisome, for example, to see that some Fed officials seem to not yet be convinced about cutting rates further before year-end. For example, on Monday September 30, Chicago Fed President Charles Evans said: “What we’ve done already might be sufficient, I’m open minded to suggestions that we might need more. At the moment I’m going to be looking at the data.”[i] Arguably, it would be best for equity markets if public comments from Fed officials were consistent with the high likelihood already priced in by markets of another quarter point cut at one of the last two FOMC meetings of 2019.
The current Brexit deadline is October 31, and it has been more than three years since voters in the UK passed their historic referendum to leave the European Union. Are we only weeks away from this finally happening?
Arguably, the biggest mystery in markets today is whether Brexit is going to finally happen at the end of this month.
The UK Parliament recently passed legislation to prevent a no-deal Brexit, and the UK’s Supreme Court ruled that Prime Minister Boris Johnson’s suspension of Parliament was unlawful. Notwithstanding, Johnson continues to insist that the UK will leave the EU on October 31.
By the end of August, the Predicit betting market was suggesting a greater than 50% probability of Brexit occurring by November 1st. That probability plummeted in early September when the House of Commons passed legislation to force a delay.
It appears that Johnson will deliver to the EU in the coming days a new Brexit proposal, the central feature of which would be the elimination of the backstop deal his predecessor Theresa May crafted and instead installing customs checks between Northern Ireland and the Republic of Ireland. It’s a long shot attempt to reach a deal with EU leaders who will be meeting on October 17-18.
If a deal isn’t reached, it’s unclear whether Johnson will simply force Brexit to happen automatically on the Halloween deadline, even though many UK lawmakers will call it unlawful. Given that Johnson’s rise to become Prime Minister was rooted in his promise to deliver Brexit “deal or no deal” and that his top adviser, Dominic Cummings, was the chief architect of the 2016 “Vote Leave” campaign, it’s possible that Johnson will ignore Parliament, force a no-deal Brexit, cast the dispute as the people versus the establishment, unveil major tax and trade plans to support the no-deal economic scenario, and call on lawmakers to hold new elections – thereby leaving his leadership and policy methods to the will of the people, rather than to Parliament. It would be a major economic and political gamble.
Currently, the Predictit betting market gives only a 21% probability of an official Brexit occurring on November 1. This could be an underestimation. It’s likely in our view that this variable will heat up in the coming weeks and markets will be dealing a serious possibility of Brexit actually happening at month-end.
What’s the probability of a comprehensive agreement between the US and China by year-end?
In sum, the trade conflict with China is arguably so large and multi-faceted that a comprehensive agreement is highly unlikely to happen soon. That said, it’s very possible we will see a partial agreement.
First, to understand the enormity of the trade dispute with China, it’s important to understand the perspective of the Trump Administration. In December 2017, the Administration released its National Security Strategy for the United States, making clear that the country “will no longer tolerate economic aggression or unfair trading practices.”[ii]
Then on June 28, 2018, in a speech at the Hudson Institute, White House trade advisor Peter Navarro outlined six strategies of economic aggression used by China against the United States:[iii]
1) Protect China’s Home Market from Imports and Competition;
2) Expand China’s Share of Global Markets;
3) Secure and Control Core Natural Resources Globally;
4) Dominate Traditional Manufacturing Industries;
5) Acquire Key Technologies and Intellectual Property from Other Countries, including the United States; and,
6) Capture the Emerging High-Technology Industries That Will Drive Future Economic Growth and Many Advancements in the Defense Industry.
Navarro then outlined fifty “acts, policies and practices that China engages in in order to promote its economy worldwide.”[iv] After discussing many of these strategies and tactics, Navarro ominously concluded his speech by saying, “If you’re in a negotiation, and you take 25 of these off the table in a successful negotiation, you still have 25 left.”[v]
From this perspective, the extent of the US-China trade dispute is simply too large to be resolved anytime soon. And, if many important issues are fixed, many other important issues will remain unresolved that will still need to be addressed.
Therefore, it’s not surprising that in August, in the face of the negotiating stalemate between the US and China as well as ever-rising tariffs, US-China relations looked like they were at a multi-year low. Importantly, though, circumstances might be turning for the better that could make it possible for a partial deal to be reached between the two countries.
First, the trade deals that President Trump is reaching with various countries (Japan, Korea, Mexico, and Canada) and the trade barriers being installed against China could be increasingly separating China from the rest of the world. This may mean China will need to flatten the playing field if it wants to play inside the US economic sphere.
Secondly, the Chinese economy seems to be progressively suffering. The economic data for August showed that China’s exports shrank by nearly 1%[vi]; arguably a dangerous development for an export-led economy. So the trade battle and US tariffs seem to be taking a toll on the Chinese economy, and putting pressure on Chinese leaders.
And lastly, as it stands now, top US and Chinese officials are scheduled to reconvene in Washington in the coming weeks. According to Peter Navarro, those talks will focus on two key issues: ending China’s policy of subsidizing state-owned companies and opening up the Chinese market to American competition.[vii]
It’s noteworthy that the talks will center on these issues and not on others, such as IP theft and forced technology transfers. This may signal that both sides are focused on small wins, rather than getting everything done at once, which will be much harder.
It’s unlikely a comprehensive trade deal will be reached between the US and China during the next year, but there appears to be a good chance that we’ll see a partial deal. This will probably mean that some tariffs will stay in place for a long time, but at least we’ll see some progress compared to the very pessimistic outlook that existed in early August.
What is your 2020 presidential election outlook and the policy implications?
At the moment, it appears that the presidential election will be Donald Trump v. Elizabeth Warren.
The Democratic Senator of Massachusetts has sky-rocketed in the polls and betting markets. According to a September 19-23 poll by Quinnipiac University, Warren is winning 27% of Democratic voters and independents who lean Democratic, compared to 25% for former Vice President Joe Biden; Bernie Sanders is in third place with 16%. Note in August, Biden was at 32%, Warren 19%, and Sanders 15%.[viii]
In betting markets, Warren’s prospects of winning the Democratic nomination are even more promising. According to Predictit, Warren’s probability of becoming her party’s nominee is 47%, versus 25% for Biden and 11% for Sanders. To highlight just how quickly and far she has ascended in recent months, Warren was at 19% in early July.
Warren’s notable policy positions are Medicare for All, a wealth tax, rolling back the Trump tax cuts, dividing commercial and investment banking units at large financials, and requiring private equity firms to assume debt and pension costs of acquired companies.
As we’ve highlighted before, the most sensitive sector to the election outlook has arguably been healthcare providers, which are now down nearly 20% during the last year. They’ve been notably weaker during the last month despite the strength in the broad market. We believe this is in response to Warren’s political ascendancy.
Of course, the Democratic primary season is still far off, with the Iowa Caucuses scheduled for February 3, 2020. Four months is a political eternity, and therefore anything could still happen. It’s worth monitoring Hillary Clinton for the possibility of her entry into the race. Clinton has a new book being released and will do more public appearances; and with the Trump impeachment inquiry, the argument may grow even more among her supporters and some independents that the 2016 elections were illegitimate.
Is the possibility of a Trump impeachment a major market risk? Are Republicans in trouble in November 2020?
Yes, an impeachment process could be a major market risk. But its likelihood appears low to us.
In previous client letters, we’ve highlighted our view that the Clinton impeachment events during the late summer of 1998 may have contributed to a nearly 15% decline in the S&P 500. That’s a useful precedent to consider when thinking about the market implications of a Trump impeachment, especially in light of the major, market-friendly corporate tax cuts that could be undone in 2021 with a new administration.
Of course, the validity of an impeachment inquiry and trial is currently divided along party lines. The key developments we are watching for here are whether any Republican senators would cross party lines in favor of conviction in a Senate trial, as well as the public’s appetite to impeach the President.
Removal from office would require a two-thirds majority in the Senate. Republican political consultant Mike Murphy told MSNBC’s Andrea Mitchell on September 25 that one Republican senator told him that if a secret vote were held, at least 30 Republican senators would support impeachment.[ix] But we haven’t seen more reports of that view. For now at least, there appears to be no indication that the President lacks the support of most of his party in the Senate.
As for public opinion, a recent Monmouth poll found 52% oppose impeachment and removing the President. This is hardly the support some Democratic leaders have hoped for in order to pursue impeachment. Although she supports an inquiry today, House Speaker Nancy Pelosi said in March that she opposed impeachment because: “Unless there’s something so compelling and overwhelming and bipartisan, I don’t think we should go down that path, because it divides the country.”[x]
For now, the prospects of President Trump being impeached may be overestimated by some.
Furthermore, it isn’t necessarily clear that Republicans are in trouble in the next election. President Trump may have created the most formidable re-election campaign ever. According to the Washington Examiner, Trump’s campaign and the Republican National Committee raised $125 million during the third quarter 2019, raised $308 million during the first three quarters of the year, and had more than $156 million the bank. To underscore the scale of this fundraising, President Obama raised just $70 million during the third quarter of 2011.[xi]
The Trump campaign and the RNC may raise $1 billion in this election cycle. Even more, and perhaps speaking more to the new political environment caused by the new impeachment push, on September 24th they ran a fundraising drive in response to Democrats’ inquiry. By the end of the day, $1 million was raised.
This unprecedented fundraising could be powerful given Trump’s competitive advantage in terms of voter targeting. In March, in an interview with CNN, Howard Dean, who is in charge of the Democratic National Committee’s data analytics and targeting infrastructure, acknowledged: "I think, right now, we're not competitive. [Republicans] been doing this the right way for two cycles and you know the DNC has really started out in a hole. You know, we have basically 12 months or so to get us in shape."[xii]
Furthermore, the impeachment inquiry may not necessarily be a serious political wound for Republicans, but an advantage if the public doesn’t meaningfully support the undertaking. The Clinton impeachment precedent may again be instructive. During the weeks leading up to the 1998 midterms, Newt Gingrich had been expecting to pickup 10 to 40+ seats in the House. Ultimately, Republicans lost 5 seats.[xiii]
Paul Hoffmeister is chief economist and portfolio manager at Camelot Portfolios, managing partner of Camelot Event-Driven Advisors, and co-portfolio manager of Camelot Event-Driven Fund (tickers: EVDIX, EVDAX).
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[i] “Charles Evans says Fed has turned dovish, but still might need to do more,” by Holly Ellyatt, September 30, 2019, CNBC.
[ii] “National Security Strategy of the United States of America”, December 2017, the White House.
[iii] Speech at Hudson Institute by Peter Navarro, June 28, 2019, Hudson Institute.
[vi] “China’s exports fell unexpectedly in August as US trade war continues to slam industrial economy,” by William Zheng, September 8, 2019, South China Morning Post.
[vii] “Navarro: US and China will discuss these two issues in next round of trade talks”, by Evie Fordham, September 8, 2019, Fox Business.
[viii] Warren Continues To Climb While Biden Slips Quinnipiac University National Poll Finds; Democratic Primary Is Neck And Neck”, September 25, 2019, Quinnipiac University Poll.
[ix] Andrea Mitchell Reports, September 25, 2019, MSNBC.
[x] “Pelosi: ‘I’m not for impeachment of Trump”, by David Alexander, March 11, 2019, Reuters.
[xi] “Trump and Republicans break fundraising record and bring in $125m haul”, by Zachary Halaschak, October 2, 2019, Washington Examiner.
[xii] “Money, Power, and Data: Inside Trump’s Re-Election Machine”, By Jeremy Diamond, Dana Bash and Fredreka Schouten, March 19, 2019, CNN.
[xiii] “The 1998 Elections: Congress – The Overview; G.O.P in Scramble over Blame for Poor Showing at the Polls”, by Alison Mitchell and Eric Schmitt, November 5, 1998, New York Times.